Journal Issue

Reform of Monetary Policy Instruments

International Monetary Fund. External Relations Dept.
Published Date:
January 1992
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What are some of the issues in the development of a market-based system of monetary control?

A particularly important function of a financial system in a market economy is to help mobilize a society’s savings and to channel them to the most efficient types of investments. As direct controls of credit and interest rates have led to inefficiency and resource misallocation, in recent years many developing countries have begun to reform their systems of monetary control in favor of a more active use of indirect or market-based instruments to achieve macroeconomic objectives. Market-based monetary instruments are employed to influence money, credit, and interest rates indirectly through changes in the liquidity conditions of commercial banks and other financial institutions. Many issues, however, have arisen during various stages of monetary policy reform in these countries. These issues are largely related to two questions: (1) how to make a successful transition toward a market-based system, and (2) how to strengthen the effectiveness of market-based operations.

Making the transition

Monetary policy reform takes time; it is unlikely that all reform measures can be implemented at the same time. Further, the reform of monetary control instruments and procedures both affects, and is affected by, the liberalization of the financial sector. The question arises as to which reform measures should be taken first. The answer depends very much on the circumstances faced by the country authorities, the existing institutional arrangements, and the efficiency with which organizational and legislative changes can be made. Recent experiences in many countries, particularly those in Asia, have shown, however, that the following sequencing of financial reform measures has worked well.

For a detailed version, see “Market-Based Systems of Monetary Control in Developing Countries: Operating Procedures and Related Issues,” by Chorng-Huey Wong, IMF Working Paper (WP/91/40), available from the author.

Introduction of market-based monetary instruments. Several key reforms of monetary control procedures should be implemented very early in the reform process to enable the central bank to anticipate reserve developments and to absorb or provide bank liquidity at its own initiative and in a flexible manner. Initial steps may include the introduction of new monetary instruments (e.g., treasury bills), auctioning procedures for such instruments, and changes in the rules of access to central bank refinancing facilities to facilitate the development of the auction system. An early implementation of such monetary policy reforms in Indonesia and the Philippines, for example, facilitated subsequent interest rate liberalization and financial market development.

Prudential reforms. A system of prudential regulation and supervision—including loan classification and provisioning, capital adequacy requirements, and limits on loan concentration—should be established. Weak financial institutions should be recapitalized or restructured. This would avoid bank insolvency and financial crisis that could otherwise occur in the face of rapid credit growth following financial liberalization. Strong and effective bank supervision and prudential regulation in Malaysia, for example, helped in. maintaining interest rate stability immediately following the rapid interest rate liberalization in the late 1970s. The soundness of financial institutions is vital to further development of financial markets and to effective monetary control.

Development of financial markets. The extent to which financial markets are developed and well-functioning is an important factor determining the effectiveness of indirect monetary control. As soon as the basic reforms of monetary control procedures and prudential regulation are implemented, efforts should be devoted to the development of financial markets, and to the strengthening of banking competition. At this stage, interest rates should be progressively liberalized, beginning with the interbank lending rate, and reserve requirements lowered to the extent possible. It is also essential to maintain regularity and transparency of treasury bill auctions, while allowing interest rates on treasury bills to reflect market conditions. The restrictions on the scope of bank activities should be eased and entry barriers lowered. At the same time, the central bank could provide regulatory support to market participants, including dealers, and develop a system whereby market information is effectively disseminated. On the part of the government, differential tax treatment regarding financial instruments should be removed and the government’s debt instruments should be market oriented.

It should be stressed, however, that persistent macroeconomic imbalances may hamper the success of financial liberalization. In the Philippines, for example, the failure to stabilize its domestic economy or inappropriate macroeconomic management, combined with inadequate prudential regulation and supervision, led to a financial crisis in the early 1980s.

Removal of direct instruments. A necessary step in financial reform is to discontinue the use of direct instruments once the indirect instruments are established. In order to prevent excessive interest rate fluctuations or credit expansion at the beginning of financial liberalization, however, it may be desirable for the central bank to retain some of the relatively less distortive direct instruments in its arsenal to guard against the loss of monetary control. Measures such as limiting the rate of credit expansion to that of deposit growth, or the imposition of a maximum interest rate spread for the financial institutions, may be warranted when the indirect instruments are still in their infancy. The approach taken in the Republic of Korea in the 1980s regarding the limit of bank lending rates, serves as an example. This does not mean that credit ceilings and administrative controls on interest rates should be maintained for a prolonged period while developing indirect instruments. Rather, the strategy should be to place primary reliance on indirect instruments and activate direct instruments only when necessary. As soon as the situation permits, direct controls should be eliminated.

Improving operating procedures

Operating procedures under a market-based system of monetary control vary from country to country, reflecting, among other things, different stages of economic and financial development, as well as different exchange arrangements. There are, however, several essential steps in the procedures that are common in most countries (e.g., Indonesia, Nepal, the Philippines, and Sri Lanka) that strive to achieve quantitative targets for money or credit. First, a desired path for the demand for reserve money is established, derived from an intermediate target variable (e.g., broad money) that is consistent with the ultimate policy goals. Second, a desired path for the operating target variable (e.g., net domestic assets of the central bank), based on the desired path for reserve money, is estimated. Third, on the basis of forecasts for the major elements of the central bank’s balance sheet, the projected path for the operating target variable is calculated, assuming that there are no net sales of government securities and no change in other policy instruments. Fourth, the policy response to. the deviation between the desired and the projected path of the operating target variable is decided. Several issues associated with such operating procedures have arisen that need to be addressed in order to further develop the market-based system and to strengthen the effectiveness of monetary control.

Assessment of the deviations from the operating target. In deriving the projected paths for reserve money and for the operating target variable, the changes in the autonomous factors on the central bank’s balance sheet should be estimated as precisely as possible. For this purpose, short-run economic indicators should be made available in a timely fashion. This would facilitate the central bank’s assessment regarding the nature of the deviations between the projected and desired paths of the operating target variable. In turn, this assessment would enable the central bank to decide upon the magnitude and pace of monetary corrections, whether instruments other than open market operations would be required, and whether the operating and intermediate targets should be revised. Rigid adherence to the monetary targets without proper assessment of the character of the changes in autonomous factors could result in excessive volatility in interest rates and possibly the exchange rate.

Coordination with fiscal and external sector policies. As the market-based system continues to develop, interest rates and the exchange rate become increasingly important channels through which monetary policy is transmitted to affect the real economy. It is important that monetary policy be coordinated with fiscal and external policies in order to avoid inconsistencies between targeted demand and supply in financial markets, and undesired interest rate and exchange rate fluctuations. To the extent, for example, that large budget deficits are the main cause of macroeconomic instability, a reliance on restrictive monetary policy without substantial fiscal adjustments would lead to excessively high interest rates. In the absence of capital controls, this is likely to result in large capital inflows. Further, the inflow problem would worsen if the expected rate of depreciation of the domestic currency falls short of the difference between expected domestic and foreign interest rates. On the other hand, if domestic interest rates adjusted for the expected rate of domestic currency depreciation are lower than foreign interest rates, capital outflows would be encouraged.

An important aspect of policy coordination in connection with treasury bill auctions is the link between such auctions and government domestic debt management. The preparation of a cash-flow statement for the government for the fiscal year will establish a path for government domestic borrowing. For this purpose, it is important to develop monthly projections of the main components of government expenditure, revenue, foreign grants, net foreign borrowing, and net domestic borrowing. This information will determine the total amount of government securities that should be sold outside the central bank for monetary developments to move along the desired path.

Concern about interest rate movements. Excessive volatility of interest rate movements has deleterious effects on the solvency of domestic producers and financial institutions, on domestic saving-investment decisions, and on balance of payments and exchange rate stability. Policy coordination, appropriate sequencing, and prudential reforms are expected to contribute to interest rate stability, and so is the establishment of a repurchase market, or a window, at the central bank for secondary trading in government securities.

Many developing countries are, however, concerned about upward movements of interest rates because of their implications for the budgetary operations of the government. In some countries—such as Sri Lanka prior to 1989 and Nepal since 1988—the cutoff rate in each treasury bill auction is determined by the ministry of finance, while the central bank stands ready to absorb any residual quantity of treasury bills. Such concern for the interest cost to the government, however, would limit the scope for monetary control through open market operations. Below-market yields also prevent the development of an active secondary market for government securities. Further, financial institutions holding such government securities tend to pass the implicit “tax” on to their customers through higher interest rate spreads, thus distorting the interest rate structure of the financial sector.

Developing secondary market and repurchase market. In some countries (Nepal, for example), trading in the primary market for government securities is hampered by the absence of, or the lack of development in, a secondary and/or repurchase market, which reduces the liquidity of the securities. Impediments to the development of such markets include below-market yields on the securities, statutory requirements for provident funds and financial institutions to hold substantial amounts of such securities, persistent excess liquidity in the banking system, and the lack of trading expertise and ready access to financing for dealers and other market participants.

In order to develop a secondary market in government securities, it is essential to increase the volume of transactions in the primary market, while making efforts to eliminate the above-mentioned impediments. Once a sufficient volume of securities has been built up, dealers with proper training can be authorized. The dealers will be responsible for making markets in government securities, and providing up-to-date information on buying and selling prices and interest rates on government securities with different maturities, as is the case in the Philippines, among other countries. To ensure the viability of the secondary market, the central bank should develop capital adequacy guidelines for dealers and monitor their activity and risk exposure.

The establishment of a repurchase market is important not only because it would increase the liquidity of securities traded in the primary market, but also because it would enable the central bank to correct or smooth out monetary developments between auctions. Such schemes are working well in Indonesia, Malaysia, Sri Lanka, and Thailand. Repurchase and reverse repurchase agreements should, of course, be well coordinated with the rediscount policy in order to convey the correct signal regarding the stance of monetary policy.

Frequency of transactions and adequacy of debt instruments. While at the beginning of monetary policy reform, the central bank may start with treasury bill auctions on a monthly basis, at some stage it may find that monthly auctions are not frequent enough to absorb or inject reserves of the commercial banks, or that the amounts sold at each auction are so large as to create problems for cash reserve management. Therefore, the frequency of auctions may be increased from monthly to weekly, with the monetary programming and forecasting framework modified accordingly. The increase in the frequency of treasury bill auctions would also offer more opportunities for market participants, facilitating the development of a secondary market.

At the same time, in order to satisfy different preferences of individual investors, the authorities may introduce treasury bills or other government securities with different maturities. Countries that rely on treasury bill auctions as the primary instrument of monetary control may find that, at least on occasion, the magnitude of monetary corrections is such that other monetary policy instruments or additional debt instruments, such as longer-term government securities, would also be required. Further, several instruments, such as repurchases and reverse repurchases, and secondary trading in government securities, are often complementary to the primary bill auctions.

An issue regarding the adequacy of debt instruments is the desirability of issuing central bank securities. These instruments are considered desirable because they allow greater freedom for the central bank to implement monetary policy without direct interference stemming from government budgetary considerations. This was one of the reasons why open market operations in the Philippines during 1984-86 had been largely conducted through the purchase and sale of central bank bills. However, if the objective of developing a sound treasury bill market and eventually other markets for longer-term government securities is to be achieved, it is important that central bank securities do not compete with government securities and inhibit market development for the latter. Therefore, central bank securities should not be issued and traded regularly in the market, but be employed only when the availability of government securities becomes a constraint for the conduct of market-based operations. Of course, in countries where a fiscal deficit does not exist, such as in Indonesia, this argument is moot.

Need for up-to-date economic and financial indicators. As part of the monetary programming exercise under the market-based system, the demand for money that is consistent with the ultimate policy objectives should be estimated. It is important to note, however, that financial reform may affect the demand for money function in several ways—a one-time demand shift, changes in the income and interest rate elasticities, or changes in the relative explanatory powers of its determinants. The removal of credit ceilings often would result in increased borrowing by producers, as well as consumers, to hold larger money balances at any given level of interest rates and income. Deregulations would also strengthen the role of interest rates in determining the demand for both money and quasimoney. Further, empirical results for a number of countries, including Indonesia, Malaysia, the Philippines, and Sri Lanka, have shown that the long-run income elasticities of both narrow money and broad money in the post-reform period tend to be smaller than those in the pre-reform period. This may reflect the fact that financial market development permits asset holders to economize on their money balances. For these reasons, the short-run demand for money may be unstable during the reform period. In this circumstance, it is important to develop various up-to-date economic and financial indicators and the capacity to interpret and monitor them so that a better judgment can be exercised in im-plementing monetary policy.


There are no hard and fast rules for the implementation of financial reform due to the vast differences in country characteristics and circumstances. Nevertheless, the issues discussed above reflect some lessons learned from country experiences that may be relevant to the new starters in this area. It should be reiterated that while market mechanisms are emphasized in financial reform, it is crucial to ensure the soundness of the market participants in order to avoid a financial crisis that would undermine the reform process.

Chorng-Huey Wong

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